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Remarks From the Ethics and Leadership Lecture at Dominican University

Mary L. Schapiro

Chief Executive Officer

Ethics and Leadership Lecture, "The Road Ahead in Regulation"
Dominican University

October 14, 2008

Thank you for that kind introduction, Dean Johnson. I am afraid that the Road Ahead in Regulation may have changed in just the time we have been sitting here. I'd also like to thank President Carroll for the generous invitation to speak to all of you tonight and to deliver the Ethics and Leadership lecture.

FINRA values deeply the contributions of the academic community and works closely with it to better understand the complexities of the financial landscape. And, as we've all seen, never before have those complexities become so apparent.

That's why it's so important for our society to have institutions like Dominican. For over 30 years now, the Brennan School has been an incredibly valuable resource—both to its students and the business and financial community. And your focus on ethics could not be more important to the future of our society.

Thirty years ago, American finance and Wall Street looked a lot different. To be honest, they looked a lot different 30 days ago.

But back in 1977—the year the Brennan School was founded—Time magazine ran a story with the headline, "Shell Shock on Wall Street."

What was the cause of the shell shock? Lehman Brothers and a firm named Kuhn, Loeb had announced merger plans.

That news seems very ordinary by today's standards. But back then, as Time reported, the merger "engendered much fear and trembling in the financial community." Fear that even the most venerable Wall Street houses were finding it difficult to withstand the quote "agonies of attrition" in a "perilous" marketplace.

It's clear from this article that—30 years ago—our tolerance for "shock" was much, much lower.

It's also evident that as Wall Street's tolerance for shock grew over the last 30 years, so apparently, did its tolerance for risk.

And because of that high tolerance for risk—indeed that gleeful embrace of risk, in 2008, many of the most respected Wall Street firms found themselves once again in a perilous market. Many financial institutions are finding it not just difficult, but impossible to survive. And the events of the last month, it is safe to say, have shocked even the most hardened market observers.

So how did we get here and what do we do about it? That's what I'd like to talk about tonight.

But before I start, for those who may not be familiar FINRA, let me briefly explain what it is we do.

The Financial Industry Regulatory Authority was created just last year. It was formed by combining NASD—which was a nearly 70-year-old regulator of the securities industry—and the regulatory operations of the New York Stock Exchange.

Today, FINRA is the largest, independent private sector regulator of America's securities industry, wholly funded by industry, not taxpayers, but governed by a Board that has both industry and public representatives.

Under the oversight of the SEC, FINRA licenses and regulates about 5,000 brokerage firms and nearly 680,000 individual brokers that sell stocks, mutual funds, bonds and other securities to the public.

We write rules that govern the industry's activities—most particularly governing their interactions with investors. We inspect firms for compliance with the rules, and bring enforcement actions against those who fail to comply. Those enforcement actions can result in fines, suspension or expulsion from the industry.

We also regulate, by contract, The NASDAQ Stock Market, the I.S.E. and the Chicago Climate Exchange. We operate the largest securities industry arbitration forum and other large utilities such as the BrokerCheck system—where investors can learn the background and qualifications of brokers and investment advisers, and the TRACE system, which provides trade reporting for all corporate bond transactions.

FINRA also devotes significant resources toward investor education programs, operating the largest foundation in the United States devoted to financial literacy.

The foundational rule in FINRA's rather large rule book is an ethical one: that brokerage firms must conduct their business in accordance with "high standards of commercial honor and just and equitable principles of trade."

One way to better understand today's turmoil in the markets is to take a closer look at the environment and the policies and behavior that helped produce it.

I'm not saying this crisis was caused strictly by unethical behavior. But I will say that we would be hard pressed to suggest that much of the behavior we've witnessed meets a standard of "high commercial honor."

And while my remarks will focus on the securities industry, these concerns are not unique to any one industry. As a whole, across the business community, we should be striving for high standards of commercial honor.

According to last year's National Business Ethics Survey conducted by the Ethics Resource Center, today's ethics landscape remains, in a word, "treacherous." Among the survey's most disturbing finding: that unethical behavior in America's corporate offices has returned to pre-Enron levels.

More than half of employees surveyed—56 percent—told researchers they witnessed ethical misconduct of some kind take place at work. That's a 10-point increase from 2003—following the Enron scandal and the passage of Sarbanes-Oxley—when only 46 percent of workers witnessed unethical behavior.

And just as disappointing: Only 40 percent of workers who witnessed misconduct actually reported it to management.

These are the kinds of numbers that make people ask, "Does Corporate America take the topic of individual and organizational ethics and responsibility seriously?"

It's a question that is asked of Wall Street seemingly every decade: after the junk bond and merger craze of the 1980s; after the bursting of the tech bubble; after the collapse of Enron and Worldcom and the many other accounting scandals; and after the Wall Street research analyst/investment banking conflict of interest debacle of a few years ago.

And, of course, it is a question that's being asked right now.

As someone who has been a regulator for 25 years, I have been witness to many ethical lapses by individuals and indeed, by entire firms where a culture of "anything goes" in the pursuit of profit, has been promoted. But I have also seen time and time again, and frankly, more often than not, industry professionals acting with great integrity and in the best interests of their customers.

I do believe however, given the findings of the Ethics Resource Center's report, as well as the current crisis in our capital markets, a reexamination of our ethical grounding is certainly appropriate. In other words, there is something badly broken here, but it is worth fixing.

Since the founding of this country, ethics has played a central role in our economy.

In The Wealth of Nations, Adam Smith argued that rational self-interest and competition, operating in a social framework based on moral obligations, can lead to economic well-being and prosperity—moral obligations.

Too many times self-interest has won out over moral obligation. Too often, individuals have allowed the pursuit of wealth to become mere sport—devoid of any ethical meaning or moral obligation to others.1

Back in the 1990s, I led an enforcement case against a New York brokerage firm named Stratton Oakmont. I don't expect it to ring a bell—but for regulators the name causes nightmares.

Stratton Oakmont robbed countless investors of more than $100 million—selling them artificially-inflated penny stocks through fraudulent sales practices. The firm's charge to its brokers was, "No one hangs up the phone until the customer buys or dies."

Ultimately, we succeeded in expelling the firm from the industry and Stratton's CEO went to prison.

This was a case where there was no moral ambiguity—just naked self-interest and outright illegality.

In fact, Stratton was the moral equivalent of a black hole, swallowing up not only investors' money, but their trust as well; their trust in an industry that can do so much to help Americans realize financial security.

Trust and confidence are the glue that holds the markets together. They're more important than money and more valuable than any commodity.

And the current crisis in our markets demonstrates, with all the clarity one could ever seek, that investor confidence has suffered a severe blow.

How and why did this happen?

We had an economic policy that fostered low interest rates over a very long period of time and excess liquidity chasing all manner of investments; a naïve belief that housing prices only go up; a mortgage industry that had an incentive to make loans that borrowers couldn't repay because the lender was not on the hook once the loans were packaged together and sold to investors; ratings agencies that gave their highest ratings to products the value of which they knew very little, and sometimes in order to curry favor with the issuers to secure future business; and investment banks that pushed these highly-rated—but very risky—mortgage-backed securities to investors-who bought them with little understanding of the risk they were taking.

Let's layer on that, opacity, faulty risk management tools and models, and the unchecked growth of over-the-counter derivatives connecting hundreds of financial institutions to each other in ways that were not understood. Lots of fees were earned all along the way, but few stopped to think about the consequences of their actions in the broader context of financial stability, our economy or the public interest.

In retrospect—these things are always so clear in retrospect when we finally connect the dots—we were clearly headed for a financial calamity. The toll on investor confidence has been enormous and rebuilding investor trust is not going to happen overnight. Doing so will require fundamental change on the part of financial institutions, regulators and investors to align their interests with the interests of our broader society which will now foot the bill for the excesses of the past decade.

For the industry I regulate, it will require a renewed commitment to putting the interests of investors ahead of squeezing out the last penny of margin.

It will require firms to cultivate an environment of higher ethical standards and product innovation must take place within that context.

It will require investors to understand the risk of the products they buy and exactly where they choose to stand on the risk curve.

And it will require a new way of regulating—fashioning a regulatory structure that focuses broadly on stability and on the investor, not just products and industries.

The first issue is pretty straightforward: financial firms need to put the interests of individual investors front and center. Half of U.S. households own equities and retail investors are the foundation of the U.S. capital markets. Their well-being should be paramount.

Now, certainly the story I told you about Stratton Oakmont is an extreme example. Those individuals were engaged in outright deception and Stratton was a criminal enterprise.

But ethical misconduct doesn't need to reach criminal levels in order to harm investors. What we often see is a culture of neglect or rationalization, where the pursuit of profit obscures a sense of any moral obligation to the investor.

We see it in sales pitches at early retirement seminars and for complex financial products all the time. Important details are left out; the best case scenario is emphasized; and the right questions are never asked.

It can't be acceptable to say one thing publicly and another behind closed doors.

It can't be okay to recommend a stock to a customer while in internal emails to other employees, you're deriding and belittling the company's executives, as an analyst for a major firm did a few years ago.

It can't be acceptable to recommend an inferior product to an investor because it pays a higher commission to the broker.

It also can't be acceptable to give the impression that a financial product is as liquid as cash when it isn't. Yet, in many recent cases, that happened when investors were sold auction rate securities.

Investors are learning that painful lesson now. FINRA recently reached an agreement with five securities firms to offer to repurchase from investors more than $1.8 billion in auction rate securities, at par value.

Many investors weren't informed of the risk of these products, and by the time they wanted to sell, it was too late—the window had closed.

Yet, while many individual investors were lured into buying auction rate securities last year, institutional investors and companies were dumping their shares.

In 2006, institutional investors owned about 80 percent of all auction rate securities. But by the end of 2007, that number had plummeted to 30 percent.

It's clear many institutions understood the risk in terms of their own investments, but the question is: was that information freely shared with individual investors? There was both a legal and an ethical obligation to do so.

This is where a strong ethical culture at a brokerage firm can make a real difference. And for the financial industry, it must be a culture that places the long term interests of the customer above all else.

To begin, we need to address what I view as some of the major weaknesses that have been exposed within the culture of firms—how they approach risk, the deification of innovation, the dominance of short-term thinking and questionable compensation models.

The argument can be made that there is something unethical with leveraging a firm's resources to the point where it's borrowing 30 dollars for every one dollar invested.

Management was placing huge bets and risking the firm's franchise for a little more profit.

Wall Street's compensation model, which rewards risk taking above most all else, has contributed significantly to our current crisis, as has the tendency of too many market participants—investment managers, companies and investors—to view the world quarter by quarter.

Within securities firms, one solution is to rewrite the risk-reward equation so that compensation is tied to the truly long-term success of the franchise AND the long-term performance of the investments the firm has sold to its customers.

If we allow highly-paid employees to earn their salaries based on results in the short-term, while the risks of products reveal themselves over the long-term, then we will continue to repeat these vicious cycles.

It's time for the industry to align its compensation models with the long-term interests of investors and the long-term success of the products they are selling.

And finally, we need a new way of regulating.

Let me be clear, our regulatory system failed to compensate for the failures of market discipline and failed to fully appreciate the interdependencies of financial institutions and the risks they shared. That is not to say that tremendous, heroic efforts have not been made by many regulators over the last 12 months. But it is to say, the system did not allow regulators to stay ahead of this crisis and prevent it from ever occurring.

Going forward, regulators must rely less on market discipline to correct problems. We should be much more skeptical that senior management in financial firms have a handle on, and control of, the risks they are taking and that there are incentives to keep in check the possibility that one might "bet the franchise." Regulators must question new products to ensure they fill a genuine need as opposed to just creating a mechanism simply for generating fees. Creating ever-more complex products, sliced and diced in a hundred ways simply to transfer risk just adds more risk to the system, not less. And just as importantly, we have learned the risks of relying on models—which of course work right up until the moment they don't. Going forward, regulators every day must think the unthinkable is possible and prepare for it.

This crisis has turned a bright spotlight on the limits of functional regulation—functional regulation being defined as regulating according to product lines. When each regulator is focused on a single product line—whether banking, securities, derivatives, mortgage origination or insurance—there's no one entity surveying the overall market. And when no single regulator has the full picture, systemic risks are either left unchecked or may even go unnoticed.

At the retail level, the disparate treatment of investors through different standards administered by a baffling array of regulators isn't rational. A better regulatory structure, more coherent in form and more encompassing in its treatment of different classes of investment products is a necessary step forward for markets and investors. The basic investor protections that come from full and fair disclosure, transparency, suitability and the presence of licensed and well-supervised sales people, should exist for the sale of any financial product.

The pervasive response by regulators to this crisis and the unprecedented use of taxpayer funds will likely lead us in the same direction—to a consolidated approach to the regulation of all major financial institutions capable of posing systemic risk—in other words, a 21st century regulatory system reflecting 21st century realities.

As I said at the beginning of my remarks, in the Wealth of Nations, Adam Smith described the ideal marketplace—one guided by competition and self-interest, but also by a sense of social and moral obligation.

Two hundred years later, that ideal marketplace is still the arena where all of us can participate—not just the rich and powerful or the well-connected.

The ideal marketplace is a meeting place for all individuals. It fuels creativity; it unleashes productive innovation; it advances science and understanding. The ideal marketplace is the truest expression of a society's priorities; the means by which we provide for one another; the venue for nations and individuals to pursue their dreams.

Today, we have neither an ideal marketplace nor an ideal regulatory system.

But someone once said that ideals are like stars: While you may never be able to hold them in your hands, choosing them as your guides will lead you to your destiny.

I believe the financial regulatory system is destined for meaningful and essential change, as long as we use our ideals as our guide.

And while I can't predict what shocking headlines Time magazine has in store for us 30 years from now, I am sure of one thing. The ideal marketplace will only be as strong as the moral foundation upon which it's built.

Thank you very much.

1 Reference to Max Weber's The Protestant Ethic and the Spirit of Capitalism, 1905.